European Union: OTC Derivatives - The New Cost Of Trading

EXECUTIVE SUMMARY

Over-the-counter (OTC) derivative markets are subject to
significant change as global regulatory commitments originating in
2009 take effect. In Europe, the European Market Infrastructure
Regulation (EMIR) requires standardised OTC derivatives to be
cleared through central counterparties (CCPs); derivatives which
cannot be cleared to be subject to bilateral margining arrangements
and a strengthened operational risk framework; and OTC and
exchange-traded derivatives (ETDs) to be reported to a trade
repository (TR). In addition, the Capital Requirements Directive
(CRD IV) and the Capital Requirements Regulation (CRR) increase
capital requirements for both cleared and non-cleared OTC
derivatives.

The scope of the reform is far reaching and covers the five main
asset classes: interest rate, credit, foreign exchange (FX),
commodity and equity.1 It is clear that costs will
increase as a result of these reforms, but the question is by how
much and where the burden will fall. This paper addresses the
question of how much more expensive OTC derivative transactions
will become as a result of the reforms, and estimates the cost
impact of the reform package on transactions in the EU.

The case for these changes is based on the argument that the
reforms will increase transparency to the regulator and the market,
and reduce risk for market participants. We expect the price for
this to be an additional total annual cost of €15.5bn for the
OTC derivatives market in the EU. We estimate that the incremental
costs for transactions that are subject to the clearing obligation
will be around €2.5bn per annum. The estimate for transactions
that will not need to be centrally cleared is much higher –
totalling €13bn annually.

There are three main elements to the costs that will be incurred
by OTC derivatives in future: new margin requirements; new capital
charges for exposures; and other compliance costs, mainly resulting
from additional reporting requirements. This paper provides
estimates for the incremental cost for both cleared and uncleared
OTC derivatives for the three cost categories and explores some of
the reasons for the differences in costs between cleared and
uncleared OTC derivatives. In addition to these increases in costs,
the market-making dealers2 may also see revenue fall,
e.g. if greater transparency leads to a narrowing of margins.

There are cost implications for all market participants
transacting in OTC derivatives: financial counterparties including
the market-making dealers; large buy-side customers such as mutual
funds, pension funds, hedge funds and insurance companies; and also
non-financial counterparties such as industrial companies using OTC
derivatives for hedging purposes.

The structure of OTC derivative markets is set to change as a
result of the reforms. Cost increases will lead dealer banks to
review the products they offer and possibly withdraw from certain
asset classes which are deemed to be too costly, or look to
increase offerings for asset classes where client demand is
expected to be greater. This will lead to a shift in the product
mix offered by dealer banks and as a result, usage across the
market. The increased costs for non-cleared products could move
some end-users towards less precise hedges by using cleared/
standardised OTC derivatives in place of a more bespoke (and more
expensive) derivative, leaving them with more risk on their own
balance sheet.

DATA SOURCES AND METHODOLOGY

A number of studies have attempted to quantify various aspects
of the OTC derivative reforms. This paper aims at combining all
available quantifications and providing estimates for the average
additional costs of the OTC derivatives reform package. The
analysis and estimates provided in this paper particularly draw on
the following impact assessments, studies and statistics:

The Macroeconomic Impact Assessment of OTC derivatives
regulatory reforms carried out by the Macroeconomic Assessment
Group on Derivatives (MAGD) provides detailed estimates for costs
arising from margin requirements, capital requirements and other
costs such as clearing fees. For this paper, we have used the MAGD
estimates to inform the calculations of the additional costs
arising from capital requirements, the additional collateral
required for centrally cleared transactions and the total amount of
clearing fees.

The Basel Committee on Banking Supervision (BCBS) and the
International Organization of Securities Commissions (IOSCO)
quantitative impact study (QIS).3 provided detailed
estimates for the amounts of initial margin required under the new
standards for non-centrally cleared OTC derivatives. We have used
these estimates as basis for the calculations of additional costs
arising from margin requirements for non-centrally cleared
transactions provided in this paper.

The European Securities and Markets Authority (ESMA) Impact
Assessment of EMIR implementing measures,4 includes
detailed quantifications of costs arising from the EMIR Regulatory
and Implementing Technical Standards. These cost estimates are the
basis for our calculations of compliance costs for financial
institutions, CCPs and trade repositories provided in this
paper.

Information on key market characteristics such as size
(notional amount outstanding, number of transactions) and
segmentation (proportion of transactions that are already subject
to margin agreements, share of centrally cleared transactions,
notional amount outstanding by asset classes) is taken from the
ISDA Operations Benchmarking Survey 2010 and the ISDA Margin
Surveys 2012 and 2013, and the OTC derivatives statistics of the
BIS.

Results from a survey by Deloitte and Solum Financial Partners
asking 21 banks about their approach to managing counterparty
credit risk provided the basis for the estimation of additional
costs arising from CVA charges by product.

There are a number of cost factors that we have not considered
in the calculation of cost estimates. The reasons for the omission
of these factors include the practical challenges of estimating
these costs, and uncertainties about the drivers of costs.

Specifically, costs not considered in the estimates provided in
this paper are:

Variation margin: the need to be prepared to post variation
margin at short notice will require market participants to hold
precautionary collateral available for posting. Additional
collateral costs arising from new variation margin requirements are
likely to be substantial.

Costs of model development and approval: the costs of
developing and securing regulatory approval for the required models
to calculate initial margin as well as the usually very complex
models to calculate capital charges. While these costs are likely
to be material, they are likely to be only a fraction of the
additional costs for non-cleared transactions estimated to be 1.705
bps.

Costs in terms of liquidity management and collateral
optimisation: the restrictions on the rehypothecation of collateral
in particular will make it necessary to review and adjust liquidity
and collateral management processes. The magnitude of costs arising
from reviewing and adjusting liquidity and collateral policies will
depend on the individual circumstances of each affected firm.

Table 2 – Assumptions and data sources

1. Spot FX transactions and certain types of physically
settled commodity transactions are excluded from EMIR. In this
context, the European Securities and Markets Authority (ESMA)
published a letter to the Commission on 14 February 2014, in which
ESMA asked the European Commission to clarify 1) the definition of
currency derivatives in relation to the frontier between spot and
forward and their conclusion for commercial purposes, and 2) the
definition of commodity forwards that can be physically
settled.

2. The largest derivatives dealers are organised in an
industry group referred to as the G15 (G14 until Q3 2011) and
account for around five-sixths of the market.

3. Published in the Annex of the Second Consultation
Document for Margin requirements for non-centrally cleared
derivatives.

4. Contained in Annex VIII of the Final report on draft
Regulatory and Implementing Technical Standards on Regulation (EU)
648/2012 on OTC derivatives, central counterparties and trade
repositories.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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